Nuveen finds a way out

Investment firms such as Nuveen that offer leveraged Muni Closed End Funds have been suffering an inordinate amount of stress over the past few months. The auctions of preferred securities issued by the companys' municipal closed-end funds continues to fail; leaving most of the firms in a situation where they need to either forced to redeem their preferreds or make other financing arrangements.

Earlier HingeFire articles outlined the issues in the market (see Auction Rate Stress Continues: Muni Bond Funds Impacted and Revisiting: Muni Bond Fund shorts).

Nuveen has obtained a commitment of up to $1.75 Billion to refinance the struggling auction rate preferred securities. This enables the company issue variable-rate demand-preferred instruments to replace the current ARPS. This effectively alleviates the pain be endured by Nuveen and places the firm’s Closed End Fund (CEF) products back into a liquid situation. The company has also taken steps to remarket the new shares with another financial firm.

These measures are excellent news for the holders of the Nuveen muni CEFs – most whom are common investors looking for tax-free income with minimal risk.

Nuveen gets infusion for auction rate securities

Come Watch the Death of a Bond Insurer

This week the market gets front row seats in the death of a bond insurer. In February, the forebearance for ACA Capital Holdings was extended to April 23rd. This date approaches in a couple of days and is unlikely to be extended. The outcome at this point is obvious according to most pundits, the complete implosion of the bond insurer.

The open question remains of what impact this event will have on the municipal bonds which are insured by ACA. In most cases, the expectation of the bond insurer failure is already priced into the munis. However this can not be a good sign for the jittery auction rate or municipal markets.

At minimum, mid-week will be the time to pull up a chair, grab a drink, and see how the entire situation with ACA unfolds. Will some firm magically step up and save the bond insurer? Will regulators from New York State step in? The flak from the implosion splatter across the Wall Street landscape? Will it give CNBC something to talk about instead of the mediocre first quarter earnings?

One recent BusinessWeek article outlines how Wall Street used ACA to hid loads of subprime risk with the eventual unintended consequence of sinking the entire business, including the bond insurance operations.

An associated story outlines the failure of S&P, the only credit-rating agency to follow ACA, to properly cut the companies rating in a timely manner. On December 19th, the rating agency cut ACA’s grade from A down to CCC overnight; immediately turning gems into junk.

Is your Town or County next?

The Muni debt crisis continues to unfold. The failure of the Muni Auction Rate market is forcing many local governments to pay the default rate on their bonds. These higher payments, many times more than double the standard interest rate, are putting municipalities under stress.

The most recent casualty is the $3.2 billion of sewer bonds in Jefferson County (Al) that were cut to junk status after the county said it will be unlikely be unable to pay banks holding its floating-rate debt. S&P slashed the county’s sewer bonds by six levels to B, five steps below investment grade. The county, which includes Birmingham, is struggling to find alternatives to survive the predicament.

Previous posts touched on the impending muni crisis (see Bankrupt Cities, Muni failures, and CDS stress, Auction Rate Stress Continues: Muni Bond Funds Impacted, More Credit Turmoil: The Muni Auction Rate market freezes) discussed the issues facing this market.

The obvious next question should be how this situation will impact your local government. Munis are being downgraded every day; governments are finding no buyers for new issues to refinance existing debt. Will your local services come to a grinding halt as municipalities scale back and scramble to overcome debt problems?

Bankrupt Cities, Muni failures, and CDS stress

Earlier commentary (see Will State SIV Funds bankrupt local communities?) discussed the stress that rising retirement costs, increasing payroll, and poor investments were placing on local governments. Recent headlines demonstrate this trend including the California city mulls filing for bankruptcy press and similar commentary from communities in Florida. ‘"As of April, we will not have the money to pay employees," Vallejo Councilwoman Stephanie Gomes said in a telephone interview. "It's just projected to get worse and worse.’ This situation is likely to become commonplace in 2008.

Many of these local governments have outstanding municipal bonds. In December the outlook for the muni bond market was discussed (see The Muni Bond dilemma). While a number of financial industry pundits claimed that the muni-bond sector would recover in 2008; the unfortunate reality is that the outlook over the upcoming months is bleak.

The failure in the past two weeks of the muni auction rate market simply underlines the calamity. Morgan Stanley announced the failure to auction the preferred shares for its closed end funds. Many other financial institutions were in a similar position this past week. This will all circle around as higher interest rates for communities as local governments are forced to pay default penalty rates on their muni bonds leading to further financial stress.

Adding to the credit concerns, Bill Gross of Pimco outlined this week that the CDS market is a huge systemic risk. "The conduits that hold CDS contracts are, in effect, non-regulated banks," says Mr Gross. "[There are] no requirements to hold reserves against a significant 'black swan' run that might break them." There is significant risk that counter parties will not be able to pay their obligations if the system breaks down, and the cracks are starting to show. The term “default shock” in now regularly used when discussing this $45 trillion market. ‘Credit default swaps are bigger than the US government bond and housing markets combined.’ Many skeptics view that this non-liquid market is primed for disaster as bond defaults approach historical means with minimum losses of $250 billion expected over the upcoming year.

The credit crisis has clearly spread beyond subprime; the contagion to muni-bonds, commercial CDS, and other sectors is not welcome news for investors. Systemic failure in any of these markets is likely to take down retirement plans and other major institutional holders leaving main street America effectively holding the bag. Investors should take a close look at their fixed rate investments and carefully evaluate their risk of structural failure. Common investments such as fixed rate annuities and other vehicles often hold CDS and other at risk instruments.

Similarly this is a time to cast a wary eye on the Muni Bond market despite the hype from firms that focus on selling these instruments. Investors should avoid pouring new money into muni bond funds or directly purchasing these bonds. Yield-focused investors should be concerned with the structural problems in the auction rate muni market, the failure of insurers, and local government fallout. These problems need to be resolved before the muni sector can be considered safe or viable.